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Angels: Don’t Use Convertible Debt to Fund Startup Ventures

Angels bring the “high risk” capital to seed and startup companies and deserve consummate high rewards for their home runs. But, by employing convertible debt in seed and startup investments, angels substantially reduce their returns in highly successful ventures.

Convertible debentures are debt instruments that convert into equity at triggering events. Angels and other early stage investors use convertible debt as a funding bridge until a subsequent, larger round of investment is closed, usually by venture capitalists (VCs). This bridge loan is converted to an equity investment under the same terms and conditions as the subsequent VC investment and at the same valuation, less a discount to compensate the angel bridge investors for added risk. The discount can vary from 5% to 30%, usually depending on the length of time between the closing of the angel bridge round and the closing of the subsequent VC round.

Convertible debt is inexpensive (minimal legal fees) and leaves the dreaded valuation negotiations to the VCs. When the target company has important assets (patents, capital assets, etc.), investing in an unsecured debt instrument could provide the investors with some downside protection, since distributions at a possible bankruptcy of the company would go first to debt holders before any distributions to shareholders.

The Internet bubble crushed many giddy angels and VCs who invested in seed, startup and early stage companies at outrageous valuations. Afterwards, many angels turned to using convertible debentures for seed/startup investments, as protection from down rounds, even when subsequent investors were not on the horizon. Unfortunately, using convertible debt in these circumstances can substantially reduce by 2-3X the ROI of angel investments, reducing a possible 20X return to 10X or even 7X.

Entrepreneurs and their advisors are eager to offer convertible debt to seed/startup investors. Postponing the valuation negotiation until a subsequent VC round preserves precious equity for the entrepreneurs. Furthermore, debt instruments are generally much less expensive to generate than are documents necessary to close equity rounds of investment, especially those requiring the establishment of a new preferred class of securities for the company. Noting that some attorneys offer reduced or deferred fees to entrepreneurs during startup, one could imagine attorney advisors also suggesting convertible debt for the first angel round.

But, convertible debt is seldom a good seed or startup investment for angels. How does convertible debt reduce the ROI of angel investments?

Entrepreneurs who need to raise multiple rounds of investment are asked by investors to raise enough money in each round to accomplish significant milestones, such as licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc. Accomplishing these milestones reduces risk and increases the valuation of the enterprise.

Let’s look at the valuation of a hypothetical company in the graphic below. The three stages of this company (A, B, & C) might be defined as follows:

A – a pre-revenue company with a prototype but without substantial orders

B – the same company after successful beta testing by the first customers

C – the same company after closing on additional partnerships that are substantially
ramping sales

This is a plot of the valuation of a hypothetical new venture over time, say 2-3 years. Clearly the increase in valuation of the company is not linear, because of the achievement of specific milestones substantially reduces the technology and execution risk of the company. Demonstration that substantial revenues can be generated between points B and C would be expected to be accompanied by a large step up in the value of the company.

Angel investors typically invest at the seed/start up phase of enterprise development, on the timeline between points A and B. The company is typically pre-revenue but has accomplished some milestones and identified customers interested in testing the product.

Case I: Let’s assume a VC discovers that an entrepreneur has an interesting product and is operating in a business vertical close to the sweet spot of the VC’s portfolio companies. The VC is in due diligence but the entrepreneur is running out of cash. The entrepreneur approaches angel investors for funding and explains the VCs interest to the angels but makes it clear that the VCs investment is still several months into the future (but before Point B in the chart). In this case, it might make sense for the angels to accept convertible debt in exchange for their investment, knowing that it is likely, but not assured, that the VCs will negotiate a valuation and invest within a few months. Since the angels are assuming more risk than the VCs, all parties agree that a 20% discount off the valuation of the VC round would be fair for the angels who invest earlier. (The angels also assume the risk that the VCs will decide later not to invest.)

Case II: Let’s assume the entrepreneur and angels anticipate the need for raising more capital at some point in the future, but expect the entrepreneur to achieve substantial milestones with the cash invested by the angels. We might expect those achievements to move the company to or beyond point C on the chart above. If so, the angels should expect a 2X or more step up in valuation at the time the VCs invest. In this case, it is in the best interest of the angels to invest in a preferred security, rather than convertible debt. Establishing the preferred class of stock for the angels prior to the involvement of the VCs smoothes the road for the subsequent investment by the VCs. If the angels invest in a convertible debt instrument in Case II, the entrepreneur and angels cannot possibly establish a fair discount against the valuation of the subsequent round. [The author acknowledges that this simple model suggests that VCs might invest at valuations as low as $2 million, which is highly unlikely. Nonetheless, this example remains valid in explaining the thesis that convertible debt is a poor investment for angels.)

Let’s establish some guidelines:

1. If and only if a subsequent investor (usually a VC) has a signed term sheet with the entrepreneur and has started due diligence, it may be appropriate for angels to invest using convertible debt (a bridge loan to the closing of a much larger round of funding by professional investors). In this case, the angels deserve a discount off the negotiated valuation between the entrepreneur and the VCs, probably 10% to 30%, depending on the time required to close the round.

2. If no subsequent rounds of investment are anticipated, angels may choose to invest in convertible debt but only with the conversion defined by a valuation acceptable to the angels at the time of the investment. In this case, angels may be reducing their risk somewhat in case of a negative exit. Debt holders will likely have the rights to take over assets (patents, etc.) in the case of a bankruptcy, ahead of shareholders.

3. If subsequent rounds of investment are anticipated, but no such investor has been identified, it is impossible to assess the time required to close a subsequent round. Even a poorly funded company, in such cases, can accomplish significant milestones that will raise the valuation of the company substantially. In this case, angels should never invest in convertible debt (unless the valuation at conversion is specified), even with a variable discount of the next round (say, 2% per month between the closing of the angel round and the subsequent round). Variable (or onerous) discounts usually result in the subsequent investor negotiating away a substantial piece of the discount. In this case, preferred shares are the most appropriate security for the investment.

One final comment against using convertible debt for angel rounds: Convertible debt creates misalignment between entrepreneurs and their angel bridge investors. Angels would prefer to see VCs invest at a lower valuation as the angels convert their bridge debt to equity (increasing the angels’ ownership fraction) while entrepreneurs seek VC investment at a higher valuation (maintaining more ownership for the entrepreneurs). Under these circumstances, angels may be less motivated to undertake activities that could increase valuation prior to the subsequent funding. Misalignment of entrepreneurs and investors is simply a bad practice.

Summary

For Entrepreneurs: Pursue smart money, that is, investors who can help you build a great enterprise. Smart money will likely want to invest in preferred shares in your company.

For Angels: Don’t fall in love with entrepreneurs, their products or their technology. Look at the deal terms early. Walk away from non-negotiable deals in which convertible debt with no specified valuation set at the time of your investment, especially when no subsequent investor is on the scene.

For Attorneys Advising Startup Entrepreneurs: Understand that smart angels are going to walk away from most convertible debt deals. Help your clients structure deals that are best for both sides and will tee up the company for subsequent rounds of investment.

The author thanks friends George Lipper, editor of NASVF’s NetNews and fellow angel investor, Robert C. Anderson, Esq, of Hale Lane Las Vegas for their comments on this work.

The author has made over 45 angel investments since 1980 and helped found four angel groups, the Aztec Venture Network (San Diego), the San Diego Tech Coast Angels, the Vegas Valley Angels and the Frontier Angel Fund (Whitefish, Montana). He has written the Definitive Guide to Raising Money from Angels, which is available at http://www.billpayne.com. He can be reached at bill@billpayne.com.

Reader Comments:

Bill, I like your write-up but felt compelled to provide an additional viewpoint. Your article is very succinct and covers nearly all the bases. I do believe that your teaching, however, often "robs" angels of the intrinsic value investing itself has to offer. Most organized angels are still at best, part time investors. Many commit a small chunk of "risk money" to a variety of investment opportunities and I know not a single investor who would cry over a 7x, let alone a 3x return. For argument's sake, we'll assume we are talking about angels who are members of an organized angel fund.

Your argument seems to focus less on the excitement in helping grow a great company and producing a fair, above-market return or economic development, and more about fear of leaving extra capital on the table. By over-analyzing deals or what could have been, you run risk of missing what is. An important factor in your argument that I did not see is your expected percentage of investments that fail. Assuming you want your overall fund performance to meet some minimal IRR, it's understandable that you want to swing for the fences on the wins to cover the losses - this is unfortunately at the management team's expense so the angel should be willing to negotiate to keep management motivated, ultimately maximizing potential return.

I have seen firsthand that when an angel enters a negotiation under your line of thinking, they have already determined what price they will get the stock for. Any deviations from that price to them "feels" like they are losing or diluting when in fact, they have not yet reached an agreement over price.

From an analytical standpoint, on a per-deal basis, each angel fund member is risking hardly any capital. Granted they may choose to participate side-by-side, or purchase additional "units", but each actual deal costs the angel only a few thousand dollars. For example, let's analyze one of the funds you are a member of, Frontier Angel Fund of Kalispell. Frontier has 33 members who each purchased 1 or more units for $50K apiece. The fund has just over $1.7 million. The fund makes investments between $100-200K apiece. For simplicity we could average $150K per deal. If this were the case, in the simplest of terms, each investor is risking less than $4,545.46 per deal. Out of 33 members, there may be 25 that are really excited about a company, entrepreneur, opportunity for economic development, etc. and if over-analyzing these deals or squeezing too hard, they will miss a lot of opportunities for great value (intrinsic and ROI) with very little capital risk.

Don't get me wrong, I do really like your article, but when coaching angels, you need not lose sight of some of the other reasons they choose to invest. Most lose $10K the second they drive their new Tahoe Denali off the lot and $4,545.46 seems like a ridiculous amount of capital to over-analyze what should be fun, contributive and collaborative. Perhaps out of embarrassment over the flops, or simply always wanting what you can't have, we hear more whining about the deals that got away. As such, my advice is don't "rob" angels of opportunities purely by crunching the numbers and remember the intrinsic value of investing itself.

- Mike Sparr (one of those pain in the butt entrepreneurs)

--Mike Sparr

Hi Mike-

Thanks for your feedback! In response to your first comment:

It appears you are advocating a larger philanthropic perspective for angels. In fact, if you ask angels, you will find that each has multiple motivations: give-back to the community, helping entrepreneurs, regional economic development, staying involved into their “codgerhood, etc.” But, ROI always comes to the top as an important motivation. The altruistic value of angel investors (mentoring, advising, board service) to portfolio companies is pretty clear to most funded entrepreneurs. But, without reasonable expectations of appropriate returns, angels would invest substantially less than $26 billion annually (Angel Investor Market in 2007 http://wsbe.unh.edu/files/2007%20Ana ... eport_0.pdf ).

Most of us feel that angel investors are critical components of our US entrepreneurial economy and that reasonable returns are justified. And, finally, we do have data on angel portfolio returns. See Returns to Angel Investors in Groups http://www.angelcapitaleducation.org ... aspx?id=144 . Rob Wiltbank reports therein that fifty-two percent of all of the exits returned less than the capital the angel had invested in the venture and only seven percent of the exits achieved returns of more than ten times the money invested, accounting for 75 percent of the total investment dollar returns. Clearly, this is high-risk investing. To do other than swing for the fences invites failure and ultimately less funding available for startup entrepreneurs.

And, just so you know, according to the Angel Capital Association, the average angel invests about $30K in rounds of investment totaling $300K for seed and startup deals.

Regards,

Bill Payne

--Bill Payne

In adding one analytical point to my prior comment, we should also have more information on the size of the deals (amount invested per transaction). You hit the nail on the head with regards to "cost of deal" noting that Convertible Debentures are in fact much more efficient and affordable.

I'd like to point out that a Preferred Stock Equity financing will cost the Company between $15,000-35,000 and requires approximately 9 documents, charter ammendment, often re-incorporation to Delaware, etc. If the Fund then insists the Company pays for it's expenses (most common), hopefully with a cap, we can assume another $10,000-15,000. This means that potentially $40,000 of the deal are tied up in legal fees. In addition, a Preferred Equity financing will almost always require D&O (key person + directors & officers insurance) which would range from $5,000-20,000 per year. These are likely not in the Company's budget so that means in the first 12 months alone, they are less approximately $50,000.

If a fund is only offering $100,000-200,000 per deal, it makes little/no sense for Preferred Equity financing given over 30% of the deal is spent in legal fees and insurance. This would ultimately result in the Company having too little capital (always need more) and when that occurs, by granting veto rights the Fund, they can then force a low valuation for subsequent funds and take control over the Company.

This would be a worst-case of course, and one would assume that entrepreneurs will only work with trustworthy partners, but the fact of the matter is that unless the fund is offering in excess of $500,000, Convertible Debt is most likely the best choice for the survivability of the venture and consideration of all parties involved.

I propose in your analysis that you include two key factors to your recommendations to the Entrepreneurs, Angels and Advisors: size of deal considerations (what minimum investment would warrant Preferred equity deal and costs associated) and average cost of each type of deal. Those are big gaps I see and must not go unrecognized if considering various funding options.

--Mike Sparr

--Mike Sparr

Hi again, Mike-
You bring up several important considerations.
1. The size of the round
2. The cost of the transaction
3. The cost of D&O insurance

You suggest that a single investor that provides only $100K should not be in a position to demand equity over convertible debt. I agree. If the investor does not like the terms, the investor can walk away. But, the key issue here is the size of the round, not the appetite of the investor. With legal cost what they are today, entrepreneurs raising small rounds (>$200K) should probably not consider a preferred offering requiring a new class of stock. Representing only myself, I have seldom, if ever, invested in such a small rounds. But, for rounds of $250K or more, I am seeking an equity position, not a bridge loan to convert to equity in a loosely-defined future round.

You suggest the cost of a new preferred round might exceed $40K. I would only suggest that you do some shopping. You can find very qualified attorneys who are sufficiently interested in your future business to not take so much off the top. Perhaps your investors can assist you in finding such service providers.

I guess we could also discuss whose money is being used to pay for these attorney’s fees. If the entrepreneur has no cash prior to investment, the investors’ money would then be used to pay these expenses after the round is closed. Both sides can plan for these expenses.

I do agree that some investors who demand board seats then require D&O insurance immediately after investment. I am aware of instances in which debt-holders have board seats. We do live in a litigious society but D&O insurance is less commonly purchased for very early stage companies than for later stage companies. I don’t agree that this is a critical factor in the decision of equity versus debt investment decisions. It is my experience that the cost of D&O insurance is decreasing today and often available for less than $5K.

Great comments Bill! I appreciate you taking time to elaborate. The article seemed so conclusive in advising Angels against Convertible Debt that I felt it was important to point out when it does and does not make sense. You did that very eloquently but in leaving out a minimum raise consideration or acknowledging the considerable expense of equity deals, I feared the reader might be misinformed.

Based on your response, it seems your rule of thumb is that if the investment amount is less than $250,000, it does not make sense to incur the considerable costs of a preferred stock equity financing (excluding even audited financial statements and other potential costs of a deal). I'd be willing to argue it should be $350,000 - 500,000 minimum but it's likely a matter of personal choice at that point.

Given we have established some lightweight parameters for amount invested and where the cutoff point should be (opinion of course), one must also consider how much capital is actually invested versus the total raise on the term sheet. You had mentioned that you never invest less than $250,000 in equity deals. I would assume this means you don't anticipate equity deals when issuing a term sheet for less than $250,000 but one would need to consider how much actual capital is guaranteed to the Company, in writing, upon issuing for example a $500,000 term sheet. My guess is still $100,000 - 200,000 which begs the question since the only guaranteed amount of capital is less than $250,000, should the Company not offer Preferred Equity? In a perfect world, the initial investment will attract other investors to participate and hopefully fully subscribe the $500,000 raise, but in all actuality the only assurance the Company has is the amount in writing.

If you can elaborate, or at least provide your opinion, on where those cutoff points should be in the matter of term sheet offer versus guaranteed funds, I think that would be very valuable information.

Again, thanks for your time in writing the article in the first place. I believe this will be a great reference for others, both entrepreneurs and angel investors alike.

--Mike Sparr

Mike-
Let's back up a little. While I may have recommended that entrepreneurs offer debt for small rounds (<$200K), I seldom invest in these smaller round. Most angel rounds are between $250K and $1 million. I feel that a Series A preferred round is appropriate for these size deals.
Addressing your issue re partial rounds: This is can of worms. If an entrepreneur needs $500K to achieve a milestone (positive cash flow or a goal which would substantially increase valuation), it does little good to close the round at $250K. What most of us do is tell the entrepreneur s/he has to raise the minimum close before cashing any of the checks. As you know, under-funded companies tend to run out of cash and then attempt to raise more funds without having achieved a significant increase in valuation. Going sideways or even suffering down rounds is not a pleasant situation. So my advice to entrepreneurs and investors alike is to make sure you raise enough money (early close or not) to achieve substantial milestones, so that additional funding, if necessary, can be raised at a justifiably high valuation.
Bill

These are all great points, and well thought out. I'd like to propose an idea, a new venture actually, and I am very apprehensive with what way to obtain funding. To date, I have entertained very few channels, but demand has spiked and I need to get this ball rolling.

I've briefly entertained traditional venture capital, however, herein lies the problem. It was difficult for the firm to comprehend the niche I am looking to fill in the technology sector, and it's due to my physical location. They came back with far too low of an evaluation of the proposed business' projected profits, and an obscene portion of the company was wanted in turn. Thus, one would conclude that they had faith in the methodology of the business, and the business model, but seemed to fear the unknown, or did not have a solid level of comfort in their evaluation. My projections could be through the roof, but as one who prefers to over deliver, I kept my projections at a very mediocre and reachable level. After speaking with another "Angel" investor for strictly advice, he did me the diligence of a sugar free coating. Basically, he stated that the typical VC mantra is based on 150-300% ROI within 5 years and then launch the exit strategy. He said what I needed to find was either an angel, a working partner, or leverage "convertible debt". Thus, I have happened upon your site, which is quite informative and well kept btw.

So my question is this, what is the best option for obtaining the funding I am seeking, and what is the recommended approach in pursuing it?

My projections are set for $20 Million in revenue by year 3, with $6 Million in gross profit. My funding request is for $2 Million. ( I am partnered with technologies needed that can exceed $480,000.00 for a single appliance, thus profit margins of six to seven figures in some instances )

Is convertible debt the route to pursue for my business? Thank you all in advance for the responses.

Andrew, several years have passed since I participated in the discussion and I've raised Angel and VC money and I can tell you that both have their pros and cons.

Few technology startups "need" $2 million these days to get customer traction and cash flow so you need to assess whether you can further prove your model and build more sweat equity to turn around those "obscene" equity demands and valuations.

As far as capital structure of your fundraising, you could crowdsource which is now an option thanks to recent legislation:

Relaxing some SEC rules for smaller corporations in their early years to allow more general solicitation.

---

You can go angel route and you may get further by negotiating a valuation with a lead for common stock, instead of haggling over preferred and all the caveats that come with it. If you cannot negotiate a valuation (and not too high to risk diluting early investors if you need later rounds and risk down round), then convertible debt is always an option. You can go two ways: Note with discount, or Note with Warrants.

Your best option is to hire a very experienced attorney/law firm that does hundreds of these types of transactions and they can provide you guidance. They are also a good source of leads for potential investors, and if the big firms bring you on it sort of validates your opportunity a little better for angels and VCs alike.

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